Marginal and Average Tax Rates and the Incentive for Self-Employment

The paper examines how the incentives for individuals to take up self-employment, rather than paid employment, are influenced by the marginal and average income tax rate. A model is developed in which an individual optimally chooses the supply of labor effort and the amount of tax to evade. Assuming that remuneration is more responsive to effort but that the opportunities for evasion are greater in self-employment, we find a negative relationship between self-employment and the marginal tax rate but a positive relationship with the average rate. This is supported by empirical evidence for 15 OECD countries over the 1980s.